As optimism grows among investors that a U.S. Treasury rally is about to begin, one key indicator in the bond market is sending a warning sign for anyone thinking about investing.
First, good news. Halfway to 2024 Treasuries on the threshold erase its losses for the year as signs finally emerge that inflation and the job market are indeed cooling. Traders are now betting that this could be enough for the Federal Reserve to start cutting interest rates as soon as September.
However, a potential constraint on the central bank’s ability to cut spending, and thus creating a headwind for bonds, is the growing belief in markets that the so-called contraction of the economy neutral rate — a theoretical level of borrowing costs that neither stimulates nor retards economic growth — is much higher than policymakers currently forecast.
“The significance is that when the economy inevitably slows, there will be fewer rate cuts, and interest rates over the next ten years or so could be higher than they have been over the last ten years,” said Troy Ludtka, senior economist at USA at SMBC Nikko. Securities America, Inc.
Forward contracts, which specify the five-year interest rate for the next five years (an indicator of the market’s view of where U.S. rates might end up), settled at 3.6%. While that’s down from last year’s peak of 4.5%, it’s still more than a full percentage point above the average over the past decade and higher than the Fed’s own estimate of 2.75%.
This is important because it means the market is placing a much higher floor on returns. The practical implication is that there are potential limits to how long bonds can last. That should be a concern for investors bracing for the epic bond rally that bailed them out late last year.
So far, investor sentiment is becoming increasingly optimistic. Bloomberg’s measure of Treasury yields was down just 0.3% for 2024 as of Friday, after losing as much as 3.4% for the year at its low point. Benchmark bond yields are down about half a percentage point from their year-to-date peak in April.
Traders in recent sessions have been loading opposite bets They will benefit from the greater likelihood that the Fed will cut interest rates as soon as July, as well as from demand for futures contracts that the bond market rally is on the rise.
But if the market is right that the neutral rate – which cannot be observed in real time because there are too many forces influencing it – has risen permanently, then the Fed’s current benchmark rate of more than 5% may not be as restrictive as it seems. Indeed, according to Bloomberg estimates, financial conditions are relatively easy.
“We’re seeing only a fairly gradual slowdown in economic growth, and that suggests the neutral rate is significantly higher,” said Bob Elliott, CEO and chief investment officer of Unlimited Funds Inc. In longer-term bonds, “cash looks more attractive than bonds,” he added.
The true level of the neutral rate, or R-Star as it is also called, has become the subject of heated debate. Reasons for a possible upward shift, which would mark a reversal from years of downward drift, include expectations of large and prolonged government deficits and increased investment to combat climate change.
Further bond gains could require a more pronounced slowdown in inflation and economic growth to trigger a faster and deeper cut in interest rates than the Fed currently assumes. A higher neutral rate will make this scenario less likely.
Economists expect data next week to show the Fed’s preferred measure of core inflation slowed last month to an annualized 2.6% from 2.8%. While this is the lowest rate since March 2021, it is still above the Fed’s 2% inflation target. And the unemployment rate has been at or below 4% for more than two years, the best since the 1960s.
“While we’ve seen individual households and businesses hurt by higher rates, overall as a system we’ve clearly handled it very well,” said Phoebe White, head of U.S. inflation strategy at JPMorgan Chase & Co.
Financial market results also suggest that Fed policy may not be restrictive enough. The S&P 500 has hit records almost daily, even as shorter-maturity inflation-adjusted rates, which Fed Chairman Jerome Powell cites as a benchmark for assessing the impact of Fed policy, have risen nearly 6 percentage points since 2022 of the year.
“We do have a market that has proven incredibly resilient in the face of higher real yields,” said Jerome Schneider, head of short-term portfolio management and financing at Pacific Investment Management Co.
With the exception of a few Fed officials such as Gov. Christopher Waller, most policymakers are moving to the higher-neutral rate camp. But their estimates varied widely, from 2.4% to 3.75%, highlighting the uncertainty in forecasting.
Powell, speaking to reporters June 12 after the conclusion of a two-day central bank policy meeting, appeared to downplay its importance in the Fed’s decision-making, saying “we can’t know for sure” whether neutral rates have risen or not. .
For some market participants, this is not something unknown. This is a new higher reality. And this is a potential obstacle to the rally.